A financial exchange is a market, physical or electronic, in which shares, options, derivatives, futures, and other units of financial instruments are bought and sold. Financial instruments include, for example, equities, stocks, bonds, commodities, indexes, exchange-traded funds, and other instruments.
Exchange-traded funds (ETF), also known as exchange-traded products (ETP), are securities that represent a legal right of ownership over an underlying portfolio of securities or other assets held by the issuing fund. The assets held in an ETF may include individual stocks, bonds, cash, commodities, derivatives, or any tradable asset, including contracts based on the value of any of the foregoing. Shares of an ETF are designed to be listed on a securities exchange and traded over the exchange just like other securities. ETFs thus allow an investor to own a set or “basket” of assets by simply purchasing shares in the individual ETF.
ETFs have sometimes been viewed as a more liquid alternative to mutual funds. ETFs enable investors to gain a broad diversification and can be traded during market hours. In addition, ETFs enable institutional investors to quickly enter and exit positions, making them a valuable tool in situations where cash is needed to be raised quickly. Institutional investors may buy or sell creation units, which are the baskets of the underlying shares which make up each ETF.
A financial exchange matches bids to buy a particular financial instrument, such as a security, equity, option, or other instrument, with offers to sell that particular financial instrument and to identify a price and volume at which a trade for the financial instrument can be executed. The introduction of electronic trading systems into such exchanges has enabled investors to place orders for financial instruments over a computer network and receive the status of orders in near real time. These trading systems also report prices at which financial instruments are quoted, bought, and sold to reporting entities that consolidate trading information and disseminate trading data, such as a best bid or offer (BBO) for the financial instrument.
One advantage of such trading systems is that marketable orders generally can be executed immediately against available contra-side interests. An order is marketable when it is priced equal to or more aggressively than the contra side interest. For example, a buy order for a financial instrument is marketable when it is priced equal to or more aggressively than the current best offer for the financial instrument, and a sell order for a financial instrument is marketable when it is priced equal to or more aggressively than the current best bid for the financial instrument. In this context, more aggressive means higher for a bid to buy or lower for an offer to sell.
Lower levels of liquidity lead to greater bid-ask spreads, (i.e. spreads in prices between bids and offers) larger discrepancies between net asset value and the value of the underlying securities, and a decreased ability to trade profitably. It is preferable to reduce the difference in prices between the best bid to buy and the best offer to sell. Such a tighter market is better for market participants.